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NARROW BANKING

The Reform of Banking Regulation

John Kay

Narrow banking (6) 24/09/2009

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Acknowledgements

I am grateful to Amar Bhidé, Ian Byatt, Don Cruickshank, Kevin

James, Mervyn King, Michael Lafferty, Richard McManus, Paul

Smee, Adair Turner and Martin Wolf for comments on an earlier

draft. It will be obvious that responsibility for the opinions

expressed here is entirely my own.


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Introduction

In 2008, the British government, like the governments of

other western countries, was faced with the alternatives of watching

economic collapse or granting massive subsidies and guarantees to

financial institutions. Despite bailouts of almost incredible

magnitude, considerable disruption to economic activity has

occurred. Many ordinary people, in no way involved or responsible,

have lost their jobs or much of the value of their savings. It is

unforgivable that this should have happened, and unacceptable that

it should ever happen again.

The public interest in financial services has several

components. Consumers are entitled to expect that the financial

services industry will provide reliable services of good quality at low

prices. Instability is inseparable from speculative markets, but the

real economy must be protected from the most serious

consequences of instability in the financial sector. The industry

should operate profitably and be internationally competitive, with

the result that it makes a substantial contribution to, and no

demands on, the public purse. None of these objectives has been

achieved. The need for radical reform of the structure of the

industry and the way it is regulated is therefore self-evident.

Proposals for regulatory reform must be judged today

primarily by the strength of the assurance that they can offer that

mistakes made in financial institutions cannot in future inflict such


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damage on innocent individuals and businesses. By this criterion,

the measures in the White Paper published by the British Treasury

in July fail even to register on the scales.

The measures discussed in this paper are designed to secure

these public interest objectives. Their most urgent purpose is to

protect the non-financial economy from financial instability. But

they have the further objective of securing better value for money

for customers from a healthy industry. A competitive marketplace

is one in which well run businesses earn profits through domestic

and international competition, and badly run businesses go to the

wall. That is the process by which the market system promotes

innovation and economic progress, and suppression of that process

damages innovation and economic progress.

There is no necessary inconsistency between a more

competitive environment and economic stability. The proposals

made in this paper develop the concept of narrow banking – often

described as separating the utility from the casino. The model of

narrow banking is one in which all retail deposits are secured on

safe assets. The intention is that in the event of a future failure

such as that at Northern Rock or RBS, an administrator could

immediately take over the retail activities of the bank, and would

find within the bank the material and financial resources to do so.

The financial needs of individuals and non-financial businesses

would continue to be met at little or no cost to the taxpayer. It is


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important to distinguish sharply between the continued provision of

essential services and the continued existence of particular

corporate entities.

The term narrow banking sounds restrictive; the concept of

a utility boring. But as I have worked through the implications of

such a model, I have come to realise that the implications are not

restrictive or boring. The opportunities are liberating and exciting.

A much needed restructuring of the financial services industry

would establish a retail sector focussed on the needs of consumers,

rather than on the promotion of products and the remuneration of

producers. We could look forward to an industry in which new

technologies are used, not just to reduce costs, but to deliver better

services. We should establish a market in which customer

satisfaction is the measure of success. That would be an outcome

very different from our recent experience. But it is an outcome we

can – and must – achieve.


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How we got here

Within the City of London, and to some degree outside it,

there is nostalgia for a time when the Bank of England acted as

coordinator of a self-regulating club of financial institutions. The

implicit deal was that financial institutions were permitted to act as

a cartel in return for a commitment to conservative behaviour. In

times of difficulty, they would provide mutual support, which the

Bank would coordinate, in order to maintain financial stability. The

Bank of England, in turn, acted as advocate of City interests within

government.

That model functioned, with some degree of success, for most

of the twentieth century. But it could not, and did not, survive the

globalisation of financial markets and the deregulation and

intensified international competition which followed. These changes

had occurred well before 1997 and it is a mistake to think that the

transfer of supervisory responsibilities from the Bank of England to

the FSA was the decisive change. What is true, however, is that the

Bank of England retains from that earlier time a prestige and

authority which the FSA is never likely to match.

That prestige and authority is of some advantage in the

exercise of regulatory functions. The size and significance of the

Bank’s advantage should not, however, be exaggerated. It is far

more important to decide what regulators should do than to decide

the name of the organisation in which they do it. If we are clear


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about the nature and scope of regulation, which at present we are

not, then the design of regulatory institutions will follow.

Regulatory activity in banking has since 1988 been focussed

around the Basel agreements. Basel is the home of the Bank for

International Settlements, the prime mover in coordinating

international discussions. The key criterion is capital adequacy.

Capital requirements may be relaxed if the bank has sufficiently

robust internal risk management systems. The procedures which

meet these criteria of robustness are generally based on the ‘value

at risk’ methodology pioneered by JP Morgan.

These rules proved worse than useless. Banks entered the

crisis with capital generally in excess of the regulatory

requirements. These provisions proved not just inadequate, but

massively inadequate, for the problems they faced. Risk

management systems based on value at risk comprehensively failed

to describe either the nature or the intensity of the financial crisis

that began in 2007. During the crisis, several banks continued to

report compliant capital ratios although the pricing of their equity

and subordinated debt indicated that the market believed they were

insolvent. Certainly their continued existence depended entirely on

government support. With their reported capital ratios eroded, and

the threat that the required regulatory ratios would be increased, all

banks reacted by reducing lending into the recession. Risk

management systems based on value at risk comprehensively failed


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to describe either the nature or the intensity of the financial crisis

that began in 2007.

Capital adequacy rules not only failed in their primary

objectives but also had other material adverse effects. The

explosion of asset securitisation and the use of off-balance sheet

vehicles (SIVs and conduits) were both developed to evade the

Basel rules. Such regulatory arbitrage increased complexity and

diminished transparency in the financial system. The effect was to

conceal what was happening not just from regulators, but from the

senior management of banks.

Banks which had more capital than was needed to comply

with regulation came under pressure to reduce their so-called

‘surplus’ capital. The trend to capital inadequacy was aggravated

by the mistaken belief that the efficiency of a bank was measured

by its return on shareholders’ equity. Reducing equity was easier

than increasing returns. Regulatory sponsorship of specific risk

management techniques allowed senior managers in banks to

delude themselves that the controls implied by these techniques

were adequate.

In an uncertain world, asset values will also be uncertain, and

the margins of uncertainty are very wide. The measurement of

capital is not, and never will be, simultaneously exact or objective,

and economically meaningful. The risk associated with a portfolio of

assets is only very loosely related to the aggregate value of the


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assets. A loan to the British government involves no risk while the

potential loss from a derivative contract may be much larger than

the value of the contract. And it is a basic principle of risk analysis

that the aggregate risk of a portfolio cannot be measured by adding

up the risks of individual elements.

The relevant criterion is the potential loss from the varieties of

economic exposure in a bank’s balance sheet. Banks sought to

address this problem for their own internal purposes through

sophisticated and complex calculations using data specific to their

own experiences and practices. They failed in that endeavour even

though these banks were seriously attempting to find the answer,

not seeking to find ways round structures which had been imposed

on them externally.

No rules on capital adequacy, however complex, can account

even approximately for the varying circumstances of all the banking

institutions in the world. This problem is fundamental and is not

soluble, even if committees sit in Basel until the River Rhine, or at

least the local hostelries, run dry.

It is at first sight puzzling that so much effort should be

devoted to an activity which is futile in principle and has manifestly

failed in practice. The Basel agreements, and the growth of

financial services regulation more generally, have caused the

emergence of a regulation industry. That industry comprises

regulatory agencies, the compliance departments which are now a


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major part of all financial institutions, and an army of consultants

and lawyers who mediate between the two. All these groups gain

power and prestige from the complexity of their activities. They

have an interest in the continued expansion of established systems

of regulation, and have been given an opportunity to achieve that

by the current crisis.

The assessment of capital requirements, and the management

of risk, are properly matters of individual business judgment, to be

made by managers in consultation with their lenders and their

shareholders. They should be among the most important matters

of business judgment in financial institutions. The devastatingly

negative consequence of regulatory prescription in these areas is

that such prescription has undermined business disciplines and the

risk management responsibilities of senior executives. Rather than

imposing controls on their own traders, the senior management of

financial institutions has conspired with those traders to evade

controls which have been imposed by outside agencies. The

outcome is a culture which regards control systems as bureaucratic

burden rather than administrative tool.

In the last two years, managers of very large businesses

have, with every appearance of sincerity, blamed regulators for the

failures of their own risk control systems. The lesson for regulation

generally is that regulation which is not well directed and not

effectively enforceable is not harmless simply because it is useless.


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Such structures impede the development of market solutions and

internal processes designed to address the problems which

regulation itself fails to handle.

The lesson of the failure of the Basel accords is not that the

regime should be elaborated beyond the 400 pages of text in the

current accords. It is that the whole system should be swept away,

and the responsibility for capital adequacy and risk management

put back where it belongs – in the hands of the executives of banks,

who should then carry heavy and exclusive responsibility for failures

of control. There must be a better way. There is. It involves a

combination of tighter, but more narrowly focussed regulation and a

larger role for competition and market forces.


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The purposes of financial services regulation

The present crisis is the direct and indirect result of losses

incurred by major financial services companies in speculative

dealing (proprietary trading) in wholesale financial markets.1 The

objective has been to seek trading profits for the institution (and for

its employees, not necessarily in that order of priority) from the

exploitation of asset mispricing and regulatory arbitrage.

Proprietary trading is not concerned with, or is incidental to, the

provision of services relevant to the business needs of its

customers. Stand alone institutions which seek profit in this way are

called hedge funds.

Most retail and investment banks, and some insurance

companies – operated their own internal hedge funds. In common

with other hedge funds, those within banks made substantial losses

in the market turbulence of 2007-8. Many hedge funds were wound

up. But losses that were merely damaging to hedge funds were

life-threatening to banks. And the consequences of the failure of

these internal hedge funds were far more wide-ranging.

The effective gearing (leverage) of most hedge funds was

lower. Borrowings of hedge funds were limited by the prudence of

their managers and their principal brokers. Borrowings by banks,

however, enjoyed the benefits of a large retail deposit base, which

would have ranked equally with other creditors in any liquidation.

The existence of that retail deposit base created an expectation –


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which proved justified – that the liabilities of the bank were

effectively guaranteed by governments.

Box A

Deposit protection

Deposit protection is provided in the UK under the Financial Services

Compensation Scheme which offers compensation in the event of the failure of an

FSA authorised UK financial institution. The scheme raises funds through levies

on other authorised firms based on their turnover in regulated business. There

are five pools corresponding to different kinds of institutions and a mechanism for

distributing very large claims over the whole industry.

This scheme works well for small defaults such as those of crooked

intermediaries. It has also handled the failure of small deposit-taking institutions

quickly and sensitively. It is not designed to handle the failure of large banking

institutions. The FSCS has been faced with major liabilities as a result of the

failures of Kaupthing, Bradford and Bingley, and Landsbanki (although

Landsbanki was a branch of an Icelandic bank, rather than a UK based bank,

depositors can claim on the FSCS for amounts in excess of the compensation

provided by the Icelandic government up to the amount which would have been

available under the FSCS).

In practice, the UK government has met almost all deposit protection

liabilities. In 2008-9, the FSCS paid out £19.9 bn and levied £171m. It plans

levies of £464m in respect of deposit protection in 2009-10. Some funding has

taken the form of loans from the Bank of England to the FSCS, and other funding

for payments outside the scope of FSCS rules is directly from the Treasury.

Much of this public expenditure will be recovered in the winding up of the failed

businesses. Nevertheless, although the ultimate costs cannot today be reliably

estimated they will certainly run into several billions of pounds. The costs of

bank bailouts – loan guarantees, toxic asset insurance, and recapitalisation –

have all been met directly by public agencies.

The recent White Paper on financial services regulation2 proposes an

element of pre-funding of FSCS, but postpones this until at least 2012. But this is

not real: the existing liabilities of the scheme to the Bank of England will not be

discharged in the foreseeable future, or probably at all. In the US, banks pay risk


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related levies to FDIC, but the premia are absurdly low relative to the risks and

costs. The large failed US banks would have paid four basis points, or less. The

costs of handling the 1980’s savings and loan collapses were effectively met by

the US taxpayer, as have been the TARP and similar programmes.

The reality is that the costs of major bank failures will fall principally on

the public purse. There is little justification or rationale for recovering a small

fraction of these costs through levies on solvent institutions, which are essentially

arbitrary and distort competition. It would be better and simpler for government

to accept direct liability for deposit protection. The important corollary is that

government (not financial services companies) should also derive the financial

benefit from these guarantees, and the net costs should be minimised

(preferably at zero or below). The proposals set out in the text are designed to

achieve this result.

Viewed from another perspective, the explosion of wholesale

market activity created bank balance sheets which were much

larger – in some cases several times larger – than their deposits

from or loans to customers. Capital which would probably have

been adequate for likely losses on lending to non-financial

customers was completely inadequate in the face of major

dislocations to wholesale money markets.

That dislocation occurred in 2007-8, a consequence of the loss

of confidence in both assets and institutions. The underlying value

of many of the assets on these balance sheets could not – in the

absence of market euphoria and optimistic appraisal by rating

agencies - be assessed easily if at all. Such uncertainty cast doubt

on the value of all the liabilities of the institutions concerned. Many

wholesale financial markets simply dried up. When assets are


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complex and idiosyncratic, and therefore have no ascertainable

objective value or market price, the conventional distinction

between solvency and liquidity has little meaning. Many banks

were both insolvent and illiquid.

In the view of some financial institutions, the crisis was

caused by accounting rules that obliged them to disclose this

information. In fact the principal causes of the failure were that

banks had expanded their balance sheets excessively and were

victims of severe management deficiencies. Banks lost money on

activities that were poorly controlled and underestimated the capital

and liquidity which these activities required.

No one who points the finger at management failure,

however, should underestimate the management challenges

involved. The problems were not confined to a single institution,

but experienced generally. People who conduct speculative trading

are often, by nature, undisciplined, opinionated, and greedy and do

not fit well into the structures of large corporate organisations. The

majority of hedge funds are small, and appropriately so.

It is, however, relevant to note that many of the managers of

large financial institutions were absurdly well remunerated for

duties they failed to perform. Not all managers were inept, and

some businesses weathered the storm more successfully than

others. Nevertheless, business models that rely on outstanding,

rather than ordinary, management for their effective functioning are


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not sufficiently robust to be allowed to play a central role in the

provision of a country’s economic infrastructure.

The issue of robustness is central. No systems, however well

designed, can eliminate mistakes and failures. While good systems

seek to reduce the likelihood of mistakes and failures, a central

feature of all well designed engineering – and biological – systems

is that they are robust to the failures that will inevitably occur.

Robust systems are structured so that their failures can be

contained within a single component, or so that error correction

mechanisms come into play. In other interconnected utilities, such

as water or electricity, substantial resource – both of technical

ingenuity and capital expenditure – is devoted to ensuring that such

failsafe measures exist, which is why major disruptions are rare.

Financial services are different. But they should not – and need not

– be different.

Robust engineering systems are designed with modularity –

so that one component can fail, and be replaced, with little damage

to the whole. They have independent back up systems. They are

loosely coupled, so that small disruptions are easily absorbed. All

financial institutions apply these principles to their technology, but

similar measures are not in place – or widely thought relevant – to

the substantive operations of these institutions, or for the financial

system taken as a whole.


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As a result, relatively minor incidents – a funding deficiency at

a second rank institution like Northern Rock, the collapse of

Lehman, a business which served no important role in the delivery

of financial services to the public, or the unsuccessful speculations

of a small group of people with AIG, a very large insurance

company – proved massively disruptive. Modern developments in

financial markets have made the system less, not more, robust.

This is the central problem that the financial services industry must

address, and through systemic reform. The suggestion that

government should respond to all such failures by flooding the

system with cash is not one that can be accepted.

The credit crunch is the second major financial crisis within a

decade. It follows on the bursting of the new economy bubble in

2000. That crisis was in turn preceded by the Asian financial

meltdown of 1997. None of these incidents are likely to be

repeated in precisely the same form, and if the next crisis is to be

averted or ameliorated we need to as basic questions about the

business models and regulatory structures that have allowed these

events to take place.

There are three broad groups of market failure in financial

services:

− fraud: Financial services activities are particularly attractive

to sophisticated criminals. Preventive and punitive activity

against fraud is essential.


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− systemic risk: Failure in one part of the financial system is

liable to have serious effects on other activities and

institutions.

− information asymmetry: Many consumers of financial

services have a poor understanding of the products they buy.

They are vulnerable to exploitation and susceptible to mistake

in what may be some of the most important transactions of

their lives.

There are grounds for serious concern about the detection and

punishment of financial fraud in the UK. The reputation of the

Serious Fraud Office is poor, following a series of collapses of high

profile cases which have led to reluctance to prosecute even when

serious issues are at stake. Conrad Black and the NatWest three

were convicted in the US for activities that were mainly conducted

in the UK, where no charges were brought.

Enforcement activity in financial services is excessively

focussed on market malpractice – abuse of market participants by

the public, or by market participants of each other, rather than

abuse of the public by market participants. The failure by the SEC

to act against Bernard Madoff raises broad questions about direction

and competence. A regulatory system that cannot deal with

straightforwardly criminal behaviour will inevitably struggle when

confronted with complex errors of judgment in respected


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institutions. But fraud and near fraud have not been central to the

current crisis. Issues of systemic risk have.


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Systemic risk

The phrase systemic risk is widely used but rarely precisely

defined. In a loose sense, systemic risk describes the tendency for

the failure of a financial services business to have an impact on

many other businesses. But such impact would be felt as a result of

a failure by any large firm in a modern economy. The specific

problems which arise in financial services fall into three broad

categories - macro-prudential supervision, retail bank runs, and

counter-party risk in wholesale markets.

The financial world is particularly prone to fads and fashions.

Ostensibly sophisticated agents reinforce each other’s conventional

opinions. They then change these opinions, frequently and

abruptly. Such instability has been characteristic of financial

markets throughout history, and has frequently caused economic

damage.

Alan Greenspan, Chairman of the Federal Reserve Board from

1987 to 2007, argued that regulators should not even attempt to

restrain the instability of financial markets, because they could not

have a better understanding of asset prices than market

participants. This claim derives from ideology rather than evidence,

and Greenspan himself now appears less convinced of its merits.3

It was not difficult to observe that the New Economy bubble

was, indeed, a bubble or that banks were taking excessive risks in

2005-6. Many people in and outside financial services understood


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these things perfectly well. The FSA and the Bank of England

delivered explicit warnings about excessive risk taking ahead of the

credit crunch.4

Coordinated international action to raise interest rates in 1998

and again in 2005 might have helped mitigate the excesses which

followed. Politicians acted reprehensibly as cheerleaders for both

the new economy bubble and the housing boom. But there are few

votes in taking away the punch bowl when the party is in full swing.

Nevertheless, as William McChesney Martin, one of Greenspan’s

predecessors, famously observed, this is a responsibility of central

bankers.

Macro-prudential regulation based on intervention at the level

of the individual firm is another matter altogether. It is not clear

what those who seek a greater role for this kind of supervision have

in mind. Do they envisage, for example, that regulators might have

intervened to block the issue of new internet stocks in 1999, or to

restrict bank lending in 2006? What might the nature and terms of

such intervention have been? Or the political consequences?

Action by the FSA to slow Northern Rock’s expansion, or to

block the competing attempts by RBS and Barclays to acquire ABN-

Amro, would have led to complaints at the highest political level. It

should not be assumed that the FSA would have enjoyed support in

these circumstances. The knowledge that large financial services

companies have direct and strong political connections, and use


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them, has been and continues to be a significant influence on

regulatory activity, as does the threat of judicial review.

No public agency should have financial stability as its goal. It

is not evident what would be meant by its achievement. If financial

stability means stabilising securities prices, then it is neither

possible nor desirable to accomplish that purpose. There might be

value in central banks offering guidelines to ranges of fundamental

values – for currencies, for example, perhaps even for house prices

– and being influenced in their policy judgments by deviations from

these ranges.5

But this is debatable, and it is even more debatable whether

agencies should require the firms they supervise to act on such

guidance. It is one thing for government to influence a climate that

gives rise to exaggerated optimism or excessive pessimism, and

quite another for it to stop executives acting on what an agency

considers to be widely optimistic beliefs.

If financial stability means ensuring that no large financial

institution will ever fail, then it is probably possible for government

to achieve this, but not desirable that it should. Business failure is

a necessary by product of economic dynamism. The appropriate

public policy objective should not be to secure financial stability but

to minimise the costs of financial instability to the non-financial

economy.


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The primary source of such costs today is booms and busts in

lending activity. From 2005 – 2007, there was feast, from 2007

there was famine, and the economic consequences of both were

severe. This behaviour is caused mainly by the contagious and

febrile nature of the conventional wisdom of financial markets. The

consequences are aggravated by capital adequacy rules – the

profitability of the boom makes more lending possible, the losses of

the bust require that lending be contracted. This adverse effect

might be reduced if, as is widely suggested, capital requirements

were varied cyclically.

But such a measure largely misses the point. The capital

adequacy rules are imposed, not on lenders, but on deposit taking

institutions – reflecting a historic position in which one activity was

the mirror image of the other. But this equivalence is no longer

valid, and it is likely and desirable that in future it will be less valid.

Any attempt to influence lending through capital controls is likely to

be a further stimulus to regulatory arbitrage, escaping the control

and creating profit opportunities through useless complication. The

most important policy measure which would help address this

instability to stimulate a wider and more diverse range of lending

institutions. This might offset the present tendency for decisions to

be taken by similarly minded people in a small number of

businesses who watch each other’s behaviour closely.


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There have been runs on banks since there have been banks.

The events of 1933, when all the banks in America were closed as

Roosevelt became President, are engraved on the minds of

American policy makers. There were no bank runs in Britain during

the Great Depression. The queues outside Northern Rock in

September 2007 were the only bank run in modern British history.

When most businesses fail, what remains is shared among the

creditors. When a queue forms outside a bank, the people at the

front of the queue get their money back in full, and those at the

back may find there is nothing left. If there is to be a queue, it is

vital to be at the front rather than the back. That means that any

whiff of doubt about a bank causes the queue to form. It also

implies that a run on one bank is liable to be quickly followed by a

run on another.

The answer that the US adopted after 1933, which has been

followed around the world, is a government sponsored deposit

protection scheme for small savers. The run on Northern Rock

occurred because Britain’s deposit protection scheme was

inadequate – only savings of £2000 were covered in full - and

there was no mechanism other than general insolvency law for

dealing with a failed bank. It was impossible for the Chancellor of

the Exchequer or Governor of the Bank of England to give an

immediate and unequivocal assurance that the deposits were safe.

The run was immediately halted when the Chancellor did give such


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an assurance, on the basis that appropriate legal authority would be

provided retrospectively.

Britain has now implemented full protection for deposits of

£50,000 and introduced a special resolution regime for potentially

insolvent banks. These measures, which exist in most other

countries, should have been put in place years before. The failure

to do so is the product of a combination of resistance on the part of

banks and a British philosophy that ‘it will be all right on the night’.

It wasn’t all right on the night, a discovery which at present seems

all too likely to be repeated in the not too distant future.

Deposit protection offers effective security against contagious

bank runs. Despite the gravest international financial crisis

certainly since the 1930s and perhaps in history, there has been no

replay anywhere of the events of America’s March 1933. The main

issue in recent discussion of systemic risk has been counter-party

risk in wholesale financial markets.

A financial services business that trades actively may have at

any moment a very large number of unsettled obligations. A futures

contract, or a derivative product, will often have a life of months or

even years. There will always be amounts which are due, but which

have not yet been paid, or received. The administrator of a failed

company is still entitled to recover all debts of the company, but will

meet the liabilities only to the extent that he is able to pay.


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Counter-party risk compounds the riskiness of financial

transactions because transactions which seemed to net out no

longer do so. Other financial services businesses that were

expecting contracts to be fulfilled one month, three months, a year

from now will suddenly discover that balance sheet exposures differ

from those they had expected. The risks associated with the market

for credit default swaps (CDS) – which has grown very rapidly in

recent years – have caused particular concern.

The failure of Lehman was a traumatic event for financial

markets because the scale of Lehman’s trading revealed the reality

of counter-party risk. Not only did participants lose out: they

understood that other institutions might fail, with similar or more

extensive consequences. The world of wholesale financial markets

was suddenly more risky than had been imagined.

The average reader may be asking ‘what does any of this

have to do with me?’ and it is a good question. The answer is that

many people believe that the problem of counter-party risk is of

such magnitude that regulatory authorities should intervene to

ensure that such risks do not materialise. Put bluntly, they think

that taxpayers should bail out any institution whose counter-party

risks are sufficiently extensive – ‘too big to fail’, as this view holds

Lehman was, and as the US Treasury concluded AIG was. Put more

bluntly still, they think that taxpayers should act as unpaid insurer

of most transactions in wholesale financial markets.


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When spelled out, this proposition is so preposterous that the

fact that it can be seriously entertained provides a revealing insight

into the political power of the financial services industry and the

degree of panic which seized policymakers in 2008. The description

of the behaviour of traders and salesmen in books like Michael

Lewis’s Liar’s Poker, or more recently, Tetsuya Ishikawa’s How I

Caused the Credit Crunch is, unfortunately, not much exaggerated.

Other autobiographical accounts purvey a similar message. Most

ordinary people will respond with revulsion at the absence of ethical

values, anger at how much such people are paid, and disgust at the

lifestyle associated. That these activities take place at all is hard to

bear: that they should be subsidised by ordinary working people is,

or should be, inconceivable.

Every commercial transaction – a house purchase, or an eBay

auction – involves counter-party risk – Will the buyer pay? Will the

seller deliver the goods? As the examples of house purchase and

eBay illustrate, both market and regulatory mechanisms exist for

dealing with these problems.

In financial transactions, the traditional mechanism for

handling counter party risk was the exchange. You could only buy

or sell shares through a member of the Stock Exchange, and if you

did the Stock Exchange guaranteed settlement – if your broker

failed to pay, or to deliver the stock you had bought, the obligation

would be discharged as a collective liability of Stock Exchange


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members. The Stock Exchange was a private club that regulated

the affairs of its members and could, and did, expel them for

misconduct or lack of appropriate financial strength.

The growth of financial services regulation in the last two

decades has led to the nationalisation of a range of functions which

were previously the responsibility of self regulatory agencies – such

as exchanges – and even of the control systems of financial

institutions themselves. These functions are not, in the main, more

effectively performed by public agencies. The issue in every case is

whether the greater power of enforcement that comes from

statutory authority offsets the informational disadvantage

experienced by an external regulator, and mostly it does not.

But the formation of the FSA and the establishment of a

statutory financial services compensation scheme led to the

assumption by public agencies of responsibility for what had

previously been handled by self-regulation.. The London Stock

Exchange is now a private company whose shares are listed on the

London Stock Exchange. Some other exchanges, however, continue

to perform traditional functions including that of acting as insurer of

counter party risk.

Since the 1970s much of the growth of financial markets has

been in derivative securities, and many of these are traded ‘over

the counter’, which means that they are not necessarily

standardised or dealt through exchanges. Market mechanisms have


28 28

been created for minimising the resulting counter-party risk.

Derivatives trading companies net exposures between any two

counter-parties. Compression vendors serve a similar role in the

CDS market. The near collapse of Long Term Capital Management

was dealt with (as such matters traditionally were) by a consortium

of sound financial institutions operating under Federal Reserve

auspices but without access to public funds. In effect, the

counterparties agreed a sharing of profits or losses (ultimately

these were profits) among them.

The development of such market mechanisms is not only the

route ahead, but the only possible route ahead. Government

subsidy for all or most financial sector counter-party risk is not

acceptable. Not just because this is not an appropriate government

expenditure, but because the existence of such support undermines

the imposition of risk disciplines within financial institutions and the

evolution of market mechanisms to deal with counter party risk. The

notion that supervision will in future prevent failures such as those

of Long Term Capital Management or Lehman and therefore this

problem of moral hazard will not emerge is an engaging fantasy.

In some respects, ambiguity about the scope of government

support leads to the worst of all possible worlds. Market

participants believe that government will intervene to undermine

their losses but there is no explicit promise. Fannie Mae and Freddie

Mac, the US government sponsored mortgage insurers, illustrate


29 29

the costs. These bodies traded without government guarantees,

but markets thought the US Treasury stood behind them. As a

result, the companies were able to build up balance sheets of

astronomical proportions on the back of relatively cheap

borrowings, to the considerable benefit of their shareholders and,

conspicuously, the executives who ran them.

Although a specialist agency – employing over 200 staff – had

explicit responsibility for the supervision of the two companies, such

supervision was ineffective in the face of the lobbying power of the

regulated institutions. When Fannie Mae and Freddie Mac collapsed,

the US government confirmed the market’s expectations and took

over their liabilities, thus imposing costs on US taxpayers which

may run into hundreds of billions of dollars.

The bankruptcy of Lehman, followed immediately by the

rescue of AIG, has magnified the scale of the problem. The

economic costs of the uncertainty and disruption that followed

Lehman’s failure were substantial. But the exemplary value of the

failure, in encouraging market participants to control risks and

assess counter party exposure, was also very substantial, and this

was the reason why the US Treasury was ready to allow Lehman to

fail. Markets now, however, believe that governments take the

view that allowing the bankruptcy of Lehman was a mistake, and

that in similar circumstances in future a bail-out would be offered.

The result is that the public has experienced the disruption caused


30 30

by the Lehman failure but has not gained the benefits of intensified

concern to manage and monitor counter party risk among financial

institutions.


31 31

Regulation and supervision

Regulation should focus on the public interest, and particularly

on the interests of the public as consumers of financial services.

This requires that regulation should aim to secure innovative and

good quality services at low prices, primarily through the promotion

of competitive markets. Regulation must also guarantee the

availability and integrity of the central utility of the industry – the

payment system and the services associated with it.

This specification of tasks is very similar to the specification of

regulatory functions for other utilities, and suggest a structure

similar to that which exists in those other industries. Proposals by

the US Treasury, and the Conservative Party in Britain,6 to establish

a consumer oriented regulatory agency are clearly on the right

lines. Macro prudential supervision is properly a responsibility of

the Bank of England. It would be better if microprudential

supervision were not undertaken at all.

The financial services sector is only one of many regulated

industries. Yet it is rare for discussion of financial services

regulation to make reference to experience gained in other areas of

regulation. We regulate utilities, such as gas, electricity,

telecommunications and water; we regulate the transport

infrastructure – railways, airports and airlines: we regulate

broadcasting and pharmaceuticals.7


32 32

History shows that regulation works most effectively when it

is focussed on a small number of clearly identified public policy

problems. Most other industries are regulated, not supervised, and

neither regulators nor the businesses concerned normally use the

term supervision.

The remit of supervision is general rather than specific.

Supervision seeks to impose a particular conception of good

business practice across the industry. In financial services, the

terms regulation and supervision are used almost interchangeably.

Yet they are not interchangeable. Supervision is, by its nature,

wide-ranging: regulation is focussed.

Supervision is subject to creep – a tendency for its scope to

grow. Supervision involves a form of shadow management; but it

is almost inevitable – and wholly inevitable in the financial services

industry – that shadow management will be at a disadvantage to

the real management in terms of the competence of its staff and

the quality of information available to it.

Despite the wide scope of supervision, it is not an effective

method of regulation. Supervision is subject to regulatory capture,

an inclination to see the operation of the industry through the eyes

of the industry and especially through the eyes of established firms

in the industry. Because the supervisor’s conception of best

practice is necessarily drawn from current practice, supervision is

supportive of existing business models and resistant to new entry.


33 33

Extensive and intrusive: yet ineffective and protective of the

existing structure of the industry and the interests of its major

players. That describes financial services regulation in Britain (and

in other countries) today.

Compare the board of the Office of Water Services, which

regulates the privatised water companies of England and Wales,

with the board of the Financial Services Authority. The board of

OFWAT has nine members of whom two were previously employed

in the water industry. Three members have substantial experience

in the regulation of other industries. The other four have

backgrounds in other private industries, academia, and

government.

Eight of the eleven members of the FSA board had or have

senior positions in financial services companies. The Deputy

Governor of the Bank of England sits ex officio. The other two

members are former executives of non-financial businesses.

The difference in board composition is an appropriate

reflection of the different responsibilities of the agencies. If the

primary responsibility is supervision, the primary qualification is

management experience in comparable businesses. The objective

of water regulation is to represent the public interest against the

industry and it is knowledge of the public interest, not of the

industry, that is required. The problem in Britain is not that the

industry members of a regulatory board act as advocates of their


34 34

vested interests – most try hard to behave in a public spirited

manner. But their way of thinking is inevitably the way of thinking

of the institutions in which they have spent the largest part of their

time.

There is also a public interest in the promotion of a profitable

and internationally competitive financial services industry. This

activity, called sponsorship in most other industries, should be

distinguished from regulation and kept separate from it, as it is in

most other industries. In the BSE crisis over infected beef, a

government department responsible for both consumer protection

and industry sponsorship voiced misleadingly reassuring statements

until the problem because too serious to ignore. The crisis was a

particularly forceful example of the dangers of linking sponsorship

with regulation. The results were damaging to both the interests of

the industry and the interests of the public. Much the same has

been true in financial services.

Textbooks of regulatory history point to the lessons of the US

airline industry.8 The need for regulation to secure passenger and

public safety has been evident from the earliest days of civil

aviation. It seems plausible – it is true – that planes will be better

maintained by strongly capitalised companies with sound business

models. It is only a short further step to perceive a need to review

pricing policies, the qualifications of prospective new entrants, and

the need for their services. And so on. Airline regulation spread to


35 35

cover almost all aspects of the operation of the industry. Industry

leaders met to discuss issues such as seat pitches and the

composition of meals.

In the United States in the 1970s, this structure was swept

away by a broad based Congressional coalition. The right believed

that market forces would serve customers and promote innovation

better than regulatory solutions. The left believed that regulation

had become a cartel, a racket operated on behalf of large,

inefficient, long-established companies.

Both these beliefs were justified, as subsequent experience

showed. The deregulated market, initially unstable, grew very

rapidly. There were many new entrants: some incumbents failed,

others thrived. Consumer choice expanded, and prices fell.

Passenger needs are today generally better served, while aircraft

are safer than ever.

The financial services industry should follow this example.

Regulation should seek to work with market forces, not to replace

them. Not because free markets lead to the best of all possible

worlds – in financial services, as in many other industries, they

plainly do not. But it is much easier to channel a flow of water into

appropriate downhill channels than to push it uphill. Competition

where possible, regulation where necessary, and supervision not at

all, should be the underlying principle.


36 36

There many lessons to be learnt for financial services from

both the management and regulation of other industries. We need

to stop thinking of financial services as a unique business, whose

problems are sui generis, and whose economic role is one of special

privilege. The historic deal, which limited competition in return for

prudent behaviour, has been abrogated. Today, both consumer

protection and macroeconomic stability will be best served by the

policies to promote competition which are rightly favoured in other

sectors of the economy.

Box B

The costs of supervisory failure

There are many disadvantages of regulation as supervision, or shadow

management. One is that government is in danger of being held responsible for

failures of actual management, and hence financially liable for the losses

incurred.

Barlow Clowes was a Ponzi scheme which collapsed in 1988: the

organiser, Peter Clowes, was sentenced to ten years in prison. The fraudulent

BCCI was closed by the Bank of England in 1991. The life insurer, Equitable Life,

closed to new business, and most policyholders received less than they had been

led to expect. After the run on Northern Rock in September 2007, the company

was nationalised after much procrastination.

In all these cases, the principal responsibility for the problems lies within

the management of the businesses concerned. Clowes was a fraudster and BCCI

was corrupt. Equitable Life and Northern Rock were both dominated by autocratic

chief executives and pursued ambitious business strategies now seen as unduly

risky. It is possible, though not indisputable, that earlier regulatory action could

have reduced losses to depositors at BCCI, policyholders at Equitable Life,

investors in Barlow Clowes, and shareholders at Northern Rock.


37 37

In all these instances, there has been heavy pressure on government to

pay compensation. In the case of Barlow Clowes, the failures of regulation at

the (then) Department of Trade and Industry appear to have been egregious.

Compensation to investors was paid following a damning report by the

Parliamentary Ombudsman. The FSA and Bank of England have statutory

immunity against claims based on regulatory failure. Nevertheless the liquidators

of BCCI brought a lengthy and exceptionally costly case against the Bank of

England – the case ultimately collapsed after extended court hearings.

Following the precedent set by Barlow Clowes, the demands for

compensation for Equitable Life policyholders have been directed through the

Parliamentary Ombudsman, who has produced an extensive report detailing

alleged regulatory deficiencies. In the case of Northern Rock, the FSA’s own

report has acknowledged some regulatory shortcomings. The demands of

shareholders are focussed on the terms on which the failed company was taken

into public ownership.

If a regulator as supervisor is, to any degree, to review the business

judgments of managers of the regulated entity, it is difficult to resist the

argument that there is some shared responsibility for errors in business

judgment. That argument was presented, with varying degrees of force in each

case. Barlow Clowes was a relatively small affair: but the scale of compensation

was large relative to the amounts paid in respect of ordinary criminal injuries,

which include cases of severe bodily harm. In each of the other cases, the

amounts of money potentially at issue run into billions of pounds. Given the

earlier history of Barlow Clowes, it is thought-provoking to ask what would be the

situation if the Madoff fraud – in which the failures by the SEC do appear to have

been serious – had occurred in the UK.


38 38

Breaking up the bank

The largest source of systemic risk in the crisis of 2007-9 has

been within individual financial institutions themselves. At Royal

Bank of Scotland, the group engaged in the trading activities that

brought the bank to the edge of collapse employed barely 100 of

the group’s 170,000 staff. At AIG, 120 people in the financial

products division, based in London, caused the effective failure of

America’s largest insurance company. Contagious consequences

spread through the whole company.

You see the same bewilderment at RBS, in AIG, in other failed

businesses such as Halifax. People who have worked hard and

successfully for a business for many years discover that their

efforts, and in some cases careers, have been destroyed by

activities about which they knew nothing and which they correctly

regard as peripheral to the primary business purposes of the

organisation.

The most urgent, and in many respects simplest, mechanism

of regulatory reform is to require firewalls and firebreaks between

different activities. This reflects the strategy of establishing a

financial system more robust to failure. Such a change means

reversing, at least in part, the conglomeration which was the central

consequence of the deregulatory ‘Big Bang’ of the 1980s.

The traditional role of the bank was to take deposits, largely

from individuals, and to make loans, mostly to businesses.


39 39

Deposits were repayable on short notice but loans could not in

practice be called in immediately. Even a well run bank was

therefore potentially vulnerable if many depositors demanded their

money back simultaneously. Banks maintained extensive liquid

assets and the Bank of England, in common with other central

banks, offered ‘lender of last resort’ facilities. The guaranteed

willingness of the central bank to provide funds against good quality

assets means that a solvent bank need not fear failure.

In the modern era, financial innovation allowed banks to trade

both credit risk and interest rate risk. These developments were at

first called disintermediation and subsequently securitisation. They

meant that the credit and interest rate exposures which traditionally

had been contained within banks, and made banks inherently risky,

could be reduced or eliminated through markets.

There was quick recognition that such disintermediation also

undermined the traditional conception, and role, of a bank. Some

thoughtful commentators believed that the financial institutions of

the future would be narrow specialists. An important book

published in 1988 by a young McKinsey partner, Lowell Bryan (now

director of the company’s global financial services practice) defined

that firm’s view at the time. The title was Breaking up the Bank.9

Bryan was half right, half wrong. All of the individual

functions of established banks (with the possible exception of SME

lending) are now also performed by specialist institutions. In many


40 40

cases these functions are best performed by specialist institutions.

Monoline credit card companies are among the most competitive

and innovative consumer lenders. Specialist mortgage banks,

based on wholesale funding, have offered market leading products.

Supermarkets have diversified into simple financial services, such

as deposit accounts. Private equity houses (venture capital firms)

have transformed the provision of finance for start-up businesses.

Successful proprietary traders set up their own businesses,

attracting institutional money to hedge funds.

But, seemingly paradoxically, the trend to specialisation was

accompanied by a trend to diversification. Traditional banks

became financial conglomerates. They not only sold a wider range

of retail products but also expanded their wholesale market and

investment banking activities. The bizarre consequence was that

while the deposit taking and lending operations of banks could –

and did – use new markets to limit their risks, speculative trading in

the same markets by other divisions of the same banks would

increase the overall risk exposure of the bank by far more. But this

is to get ahead of the story.

The most dramatic consolidation was that in which America’s

largest retail bank, Citicorp, became Citigroup, the world’s largest

financial institution, absorbing investment bank Salomon, broker

Smith Barney, and insurer Travelers, and providing virtually every

financial product available. Of the four large British banks, only


41 41

Lloyds retained a UK retail focus. Building societies took advantage

of deregulation to convert into public limited companies and

diversify from their specialism in residential mortgage finance.

Germany had always had universal banks, but they had been

conservative in style; Deutsche Bank reinvented itself on

essentially Anglo-Saxon lines. Crédit Lyonnais’s rapid growth in the

1990s led to the first major failure of a modern conglomerate bank.

Its French competitors also diversified and expanded internationally,

albeit less disastrously.

In 2007-8, the process by which retail banks became financial

conglomerates ended in tears. Almost all the businesses concerned

experienced share price collapses, rounds of emergency capital

raising, and became reliant on explicit or implicit government

support to continue operations. But these financial conglomerates

not only failed their shareholders: their customers had been victims

of endemic conflicts of interest for years. At the very moment in

1999 that the 1933 Glass Steagall Act which separated commercial

and investment banking was repealed, the New Economy bubble

was illustrating once again the abuse which had led to the Act’s

passage in the first place – the stuffing of retail customers with new

issues from worthless companies which were corporate clients.

Within every diversified retail bank, there was evidence of the

fundamental tension between the cultures of trading and deal-

making – buccaneering, entrepreneurial, grasping – and the


42 42

conservative bureaucratic approach appropriate for retail banking.

It was a conflict in which the investment bankers and traders

generally came out on top.

That is, perhaps, the heart of the matter. The attractions of

financial conglomerates are more evident to the people who run

them than to their customers, employees, shareholders – or the

taxpayers who have been faced with bills of startling magnitude by

their failure. The opportunity to gain access to the retail deposit

base has been and remains irresistible to ambitious deal makers.

That deposit base carries an explicit or implicit government

guarantee and can be used to leverage a range of other, more

exciting, financial activities.

The archetype of these deal-makers was Sandy Weill,

architect of Citigroup. The Glass-Steagall Act was repealed for the

more or less explicit purpose of allowing Weill’s Travelers Group to

merge with Citicorp, after which Weill rapidly moved to eject his co-

CEO, the urbane retail banker, John Reed. Weill’s own retirement

was hastened by the reputational problems that afflicted Citigroup

after the merger. In 2007, Weill’s successor, Chuck Prince, made a

famous summation of the credit expansion in observing that ‘when

the music’s playing, you’ve got to get up and dance’.10 It was

evident by then that the world’s largest financial services business

was unmanageable and effectively unmanaged.


43 43

In Britain, Sir Fred Goodwin of Royal Bank of Scotland

presided over one of the few successful mergers between retail

banks, acquiring and revitalising the ailing NatWest Bank. Hubris

took over, however. Pitching his company to analysts as ‘the

supreme predator’, Goodwin led the takeover of the Dutch bank

ABN-Amro at the moment the credit bubble began to burst. After

recapitalisation, the British government owned more than 70% of

RBS shares. Bob Diamond, an American investment banker who

became the dominant force in Barclays, flew a little less close to the

sun. In what was, at least in his eyes, a stunning coup he captured

the remains of Lehman’s US operations after that bank’s collapse.

Citicorp, like RBS, has received massive government support

because the organisation is viewed as ‘too big to fail’. But neither a

democratic society nor a market economy can contemplate private

sector organisations that are ‘too big to fail’. Such a company

represents a concentration of unaccountable private power,

answerable neither to an electorate nor to a market place.

And ‘too big to fail’ destroys the dynamism that is the central

achievement of the market economy. Any form of selective

government support distorts competition. To win such subsidy

today, the firms concerned must, like General Motors and Citigroup,

be both large and unsuccessful. It is difficult to imagine a policy

more damaging to innovation and progress.


44 44

In principle, there is no reason why disruptive innovations and

radically new business models should not come from large,

established, dominant firms. In practice, the bureaucratic culture of

these organisations inhibits major innovation. Revolutions in

business generally come from new entrants. Many of today’s

market leaders – Microsoft and Google, Vodafone and Easyjet – are

companies that did not exist a generation ago. These companies

could not have succeeded if governments had been committed to

the continued leadership of IBM and AOL, AT & T and British

Airways.

In UK banking, by contrast, all the leading banks today are

the result of mergers between the banks which were the leading UK

banks a century ago. The expansion of UK banking operations by

the Spanish bank Santander through the acquisition of former

building societies in the current crisis may be the most significant

new entry into UK banking since the nineteenth century. Only the

oil industry (which was insignificant in 1900) has shown stability of

industrial structure remotely comparable to UK retail banking.

The assertion that in future the activities of large financial

services businesses will be supervised so that the businesses

involved will not fail represents a refusal to address the issue posed

by the emergence of managerially and financially weak

conglomerates based on retail banks. Even if the assertion that

supervision will prevent failure were credible – and it is not - the


45 45

outcome would not deal with either the political problem or the

economic problem that ‘too big to fail’ raises. An organisation ‘too

big to fail’ can show little regard for its investors, its customers, or

for elected officials – and the rows over bonuses are a clear, if

trivial, illustration of the issue. On the other hand, supervision that

succeeded in ruling out even the possibility of organisational failure

would kill all enterprise.

There should be a clear distinction in public policy between

the requirement for the continued provision of essential activities

and the continued existence of particular corporate entities engaged

in their provision. In today’s complex environment, there are many

services we cannot do without. The electricity grid and the water

supply, the transport system and the telecommunications network

are all essential: even a temporary disruption causes immense

economic dislocation and damage. These activities are every bit as

necessary to our personal and business lives as the banking sector,

and at least as interconnected.

But the need to maintain the water supply does not, and must

not, establish a need to keep the water company in business.

Enron failed, but the water and electricity that its subsidiaries

provided continued to flow: Railtrack failed, and the trains kept

running. The same continuity of operations in the face of

commercial failure must be assured for payments and retail

banking.


46 46

Financial services companies must be structured so that in the

event of an overall failure of the organisation the utility can be

readily separated from the casino. That means the establishment of

distinct narrow banks. These might operate as stand alone entities

or as separately capitalised subsidiaries of financial holding

companies. The claim that innovation in modern financial markets

makes it essential to have large conglomerate banks is precisely the

opposite of the truth – these innovations make it possible not to

have large conglomerate banks. The activities of managing

maturity mismatch, and spreading and pooling risks, which once

needed to be conducted within financial institutions, now can, and

should, be conducted through markets.

But surely finance is not like electricity? The notion that the

financial system is a utility brings an immediate frown to the faces

of financiers, who no doubt reflect on the comparatively modest

(though now less modest) profits of utilities and salaries of their

executives. But the financial system is a utility. The more closely

you look at it, the more extensive the parallels between finance and

electricity.

The essential feature of both finance and electricity is a

system which links, in real time, the initially mismatched demands

of suppliers and customers. In both industries, there is a choice

between two broad structures, hierarchy or markets. Coordination

can be achieved by a single integrated organisation – which in


47 47

practice must be publicly owned or behave as if it were a public

agency rather than a private business. Or coordination can be

accomplished through a competitive market place, with a core

monopoly utility – the grid, the payment system –tightly regulated

on price, service quality, and access.

In both electricity and finance, there has been a shift from

hierarchy to market, from public monopoly to private ownership and

competitive markets. Until the 1970s in Britain, and to a later date

in France and Germany, cartelised retail banking operated as a

privately owned public utility. In electricity, the adoption of a more

competitive market structure was a deliberate, planned choice: in

banking it happened more accidentally, with unintended and now

disastrous results. (In an interesting anticipation of events in

financial markets, Enron developed an investment banking model in

electricity markets, caused large scale disruption to electricity

supplies on the west coast of America, and then went spectacularly

bust). It is salutary that the activities of Enron caused instability in

electricity markets but its demise did not.

Electricity is not less complex than finance, and the range of

skills required to deliver electricity is wide-ranging. The technical

knowledge required to judge safety in a nuclear plant is very

different from the expertise required to maintain stability in a high

voltage transmission network. Few people have both, and it is not


48 48

likely that those who do also have the managerial skills needed to

run large organisations.

The same diversity of required skill is true of banking. Much

has recently been made of the need for ‘banking expertise’, but

banking expertise is no more specific than ‘electricity expertise’.

Modern banks – especially financial conglomerates – need a very

wide range of technical knowledge and organisational capabilities,

and must look to different people for different skills. They also need

more effective outside challenge to their conventional thinking that

they have received. In the present crisis, and even more in the

years that preceded it, the financial services industry suffered far

more from lack of management skills than it did from lack of

expertise in financial services.

The market mechanism for securing competent management

is the prospect of failure. A special resolution regime must enable

the activities of the narrow bank to be continued under public

supervision or administration – supervision is obviously appropriate

at this point – while the remaining activities of the company are

liquidated. In some cases, the operation of the utility activity may

require injection of public funds. In no circumstances should there

be public support, or government underwriting, of non-utility

activities. The normal principle should be that financial institutions

that cannot function without government support or subsidy,

including so called ‘lender of last resort’ facilities,11 should be put


49 49

into resolution. If they are unable to rectify their problems without

public assistance the corporate entities concerned should be wound

up and their senior management removed.


50 50

Narrow banking

Narrow banking is often described as ‘a new Glass-Steagall’.

The Glass-Steagall Act, passed in the US in 1933, required the

separation of investment and commercial banking. Its most famous

consequence was the division of the House of Morgan into a

commercial bank, J P Morgan, and an investment bank, Morgan

Stanley. The sentiment behind the expression ‘a new Glass-

Steagall’ – the separation of utility from casino banking – remains

entirely appropriate, but that specific measure would not now

achieve the desired purpose.

The Glass-Steagall Act had been outdated by the increased

scope and complexity of financial markets well before its final repeal

in 1999. Although few of the activities which have led to the

failures of predominantly retail banks in 2007-8 would fall within the

scope of retail banking as traditionally conceived, many of them

could properly be classified as commercial rather than investment

banking. It is in proprietary trading that conglomerate banks have

made catastrophic losses, but these activities differ only in scale

and motivation, not inherent nature, from the treasury operations

which a commercial bank might properly undertake in its normal

day to day business.

The description below is an illustration of how narrow banking

might be defined, intended to give sufficient detail to permit


51 51

discussion of the specifics of how the proposal might be

implemented effectively and its advantages and disadvantages.

Narrow banking implies the creation of banking institutions

focussed on the traditional functions that the financial system offers

to the non-financial economy

- payments systems (national and international), for institutions

of all sizes

- deposit taking, from individuals and small and medium-sized

enterprises.

Only narrow banks specialising in these activities could

describe themselves as banks. Only narrow banks could take

deposits from the general public (deposits of less than a minimum

amount, say £50,000). Only narrow banks could access the

principal payments systems (CHAPS or BACS), or qualify for deposit

protection.

Narrow banks might (but need not) engage in consumer

lending, lend on mortgage, and lend to businesses, but would not

enjoy a monopoly of these functions. Narrow banks could be

subsidiaries of other companies (including financial holding

companies) and initially generally would be. Thus Barclays Bank

might be the narrow banking subsidiary of the Barclays Financial

Group. Over time, it is likely that while some narrow banks would

be members of a group of financial companies, some would be


52 52

members of other groups, especially retailing groups. Others still

would be stand alone institutions.

In a free market, narrow banking would have emerged

spontaneously and immediately. As a result of recent history,

depositors would strongly favour conservative, transparent

institutions which eschewed complex financial instruments and

demonstrated comprehensible balance sheets and organisational

structures. The reason this outcome has not emerged is that

government intervention has distorted the market. All savers enjoy

equal deposit protection, however risky the activities of the

institution with which they save. Those who save with large

financial conglomerates enjoy the further reassurance that comes

from frequent reiteration of the slogan that these businesses are

‘too big too fail’. The outcome of market forces has been

suppressed, and the natural outcome of market forces – narrow

banking - should be imposed by regulation.

Narrow banks would be regulated, not supervised. The

regulator would monitor compliance with the rules governing narrow

banks, but would not review the business strategies of banks or

take a view on whether they are well run businesses. If the

regulator doubted the ability of a narrow bank to meet its

obligations, the preliminary steps of the resolution procedure would

begin. There are several ways in which the activities of narrow

banks might be constrained: explicit restriction on the range of


53 53

activities of a narrow bank, special rules governing creditor priority

in liquidation, and reserve requirements.

In other regulated industries, the best approach to definition

of the regulatory regime has been the prescription of a licence.

Legislation would define the obligations of the regulator. The

primary obligations would be the protection of depositors and

regulation of the prices and terms of access to payments systems.

The obligations of licensees – the narrow bank and the managers of

payment systems managers – would be defined in their licences.

The licence might define the regulated activities of the narrow

bank – deposit taking and access to the payment system. There

would be a class of activities which would be prohibited –

particularly acting as issuer of securities and securities trading for

purposes other than the facilitation of narrow banking objectives.

The debate between principles and rules, which has been

extensively discussed in financial services, is the product of a

regime based on supervision, not licensing, and would disappear.

Some licence obligations would be of a general nature –

protection of the interests of depositors – and others would be

specific – the terms of access to the payment system. The licence

would be capable of amendment, but not easily –utility legislation

provides for amendment by agreement or, failing that, reference to

the Competition Commission.


54 54

The constitution of the regulatory authority, and its

composition, would look more like that of OFWAT than the existing

FSA. Not only would the board and staff be drawn from a wider

range of backgrounds, but the specific expertise that would be

valued in board members would be regulatory rather than financial

services expertise. The same would be true, though to a lesser

degree, of the senior executives of the agency. A substantial

category of activities would neither be explicitly permitted nor

prohibited. But if these activities grew to be the principal part of its

business the company would cease to be eligible for a narrow

banking licence.

An objective is to prohibit narrow banks from engaging in

proprietary trading. But I have already noted that trading is hard to

define, because distinguishable only by its scale from the necessary

treasury functions of any bank. This does not mean that legal

restriction is wholly ineffective. If the scope of a narrow bank’s

wholesale market activity became inappropriately large, a warning

to the board of the licensed institution concerned would normally

have the desired effect.

If these restrictions on the activities of retail banks had been

in place before 2007, they would have limited the trading losses

incurred by retail banks. These losses might still have been large,

and there might in addition have been substantial losses from bad

lending. While this form of narrow banking would provide greater


55 55

protection for depositors (and the taxpayer who stands behind the

depositors) than currently exists, that protection would still be

inadequate to protect the taxpayer interest. Such restriction would

not provide sufficient protection for depositors, or have prevented

the failure of Northern Rock.

An additional measure would give retail depositors (and, in

their shoes, the deposit protection scheme) priority over general

creditors in a liquidation. That requirement has many attractions.

It almost certainly would have prevented the Northern Rock failure:

if the retail deposit base had enjoyed priority, and since the pool of

securitised mortgages was not available to creditors, the assets to

which Northern Rock’s unsecured creditors would have had recourse

would have been very limited. In these circumstances, it is unlikely

that wholesale markets would have extended credit to support that

company’s rapid expansion (provided, of course, those markets did

not gain reassurance from the belief that Northern Rock was ‘too

big to fail’).

In this way, the measure uses market forces rather than

supervisory judgment to enforce appropriate business discipline.

Northern Rock would have been obliged to maintain substantial

liquid assets to support its retail deposits, but a diversified, well

capitalised bank like HSBC would have been able to operate much

as before.


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Effective market discipline is contingent on a clear

understanding that governments will not subsidise failed banks.

The events of the last two years represent a huge step backward.

It is likely that the damage which has been done to market

discipline on risk-taking by indiscriminate government support will

in the long run, and perhaps quite soon, outweigh any benefit

derived from increased supervision. It is essential that government

move as quickly as possible to define and limit the scope of

intervention, and put in place structural measures that make these

limits credible.

It is inevitable that politicians will be under pressure to give

subsidies to failing businesses. Even if the failed business itself

enjoys little political sympathy or support, there will be pressure

from other companies to prevent a bankruptcy that would entail

widespread financial and employment losses. A government that

does not want to save AIG may nevertheless want to save Goldman

Sachs from the consequences of AIG’s failure. In financial services,

however, the employment issues are generally less significant than

in – say – manufacturing or retailing, since the retail activities of

the bank will normally continue under different ownership and

management.

It is difficult to overstate the economic damage imposed by

the ‘too big to fail’ doctrine. The direct cost to taxpayers is evident

enough (although the bills have mostly yet to be paid). ‘Too big to


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fail’ gives an artificial advantage to large firms and to

conglomerates, with predictable effects on prices and service

quality. By favouring established firms, it chills innovation in

products and business processes. It encourages risk taking, and

encourages the employment of risk takers in large retail

institutions. Within them, it encourages the senior management to

focus on trading activities at the expense of customer service.

Many of these effects are already evident. The objective should be

that in future government support of failed and failing banks should

be at least as rare, and at least as stringent, as government support

of failed and failing non-financial businesses.

The most effective way to ensure that public subsidy to failed

financial institutions is not required is to insist that retail deposits

qualifying for deposit protection should be 100% supported by

genuinely safe liquid assets. Ideally, this means government

securities, since nothing else has assured safety and liquidity. The

model presented here does not require this restrictive view of asset

quality. But this restriction is both feasible and desirable.

The inclusion of other assets would require a regulatory

assessment of asset quality. Undoubtedly there are good quality

corporate credits, and even good quality synthetic securities but

granting regulatory significance to ratings by private agencies

proved a disastrous mistake, stimulating extensive regulatory

arbitrage. These ratings should no longer play any role in financial


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services regulation. The effect would be to ensure that agencies

have to demonstrate the value of their services to investors in the

marketplace. The agencies themselves should not be regulated.

Insistence on adequate security for government guarantees

is a logical response to the use of the government guaranteed

deposit base as collateral for speculative activities. The government

currently underwrites retail deposits in return for a position as

unsecured creditor of the bank. The difference between the market

prices of the two kinds of obligation is a measure of the subsidy to

banking institutions.

Since the subsidy is larger the worse the quality of the bank’s

assets, the subsidy represents a severe distortion of competition

which increases, perhaps substantially, the overall level of risk in

the banking sector. This is the mechanism that allowed Icelandic

banks, with poor quality lending books, to compete unfairly with UK

domestic institutions at the substantial expense of the UK taxpayer.

Narrow banking eliminates this costly and damaging distortion of

competition, and does so far better than risk related premia (which

whenever implemented has proved wholly inadequate to reflect the

actual risks involved). There is a case for private provision of

deposit insurance, but at present there is no credible provider.

Narrow banks would be free to engage in retail lending

activities. They would have to raise funds for these purposes in

wholesale markets, through securitisation and conventional


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borrowing. Narrow banks would make their own decisions, guided

by the availability and price of funds, as to the equity capital they

needed to support their lending. In the short term, it would be

likely that much wholesale funding would be provided by

government, as it is today. In the long run the quality of the

lending books that narrow banks would establish should enable

them to obtain funds on the fine terms formerly available to soundly

managed and well capitalised financial institutions. As I describe

below, money market funds might be a substantial source of such

wholesale funding.

In the United States, around $5 trillion of bank deposits are

federally insured, equivalent to around 35% of US GDP. In

addition, money market funds have assets of around £3.5 trillion.

There are, incredibly, no measures of the scale of insured deposits

in the UK but it would seem likely that their current size is a little

less than UK national debt of about £700bn. This latter figure is

likely to double over the next five years. The volume of

government stock required to provide collateral for UK bank

deposits is therefore large, but not unmanageably large, relative to

the scale of the UK gilts market.

The demand from narrow banks and other sources for

government guaranteed debt might exceed the amount of debt the

government needs to issue and to meet its funding needs. This is

true in current market conditions, and might be true in the long


60 60

term despite the likely revival of confidence in the financial sector

and the growth in government borrowing. If so, the government

should borrow more than it needs and lend the money back to first

class lending institutions. This is strongly preferable to the issue of

free credit insurance for private sector liabilities, and would enable

government support of the financial system to be better targeted

than now. Government might still be, as now, a supplier of

wholesale funds. But the aim should be to become a price taker in

the inter bank market – government would let the market decide

the value of its guarantee, and taxpayers would benefit from the

premiums (as, since they bear the costs, they should).

Would restriction of the investments of narrow banks

significantly reduce the returns paid to UK savers? There is no

reason why a sound bank should pay more for retail deposits, net of

the cost of attracting and collecting them, than it pays for wholesale

money. Historically, LIBOR has exceeded base rate by, on average,

only a few basis points. In normal conditions there should be little

effect from the restriction of narrow banking assets on the rates

paid on deposits.

The best rates on offer to retail savers have typically

exceeded both base rate and LIBOR, despite the costs of

administering these deposits (although these retail rates are usually

only offered for deposits, such as internet deposits, for which the

costs of administration are very low). High rates are in some cases


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offered by banks which cannot access wholesale funding on

competitive terms – as with the Icelandic banks. These banks

should not have been permitted in the past, and certainly should

not be permitted in future, to solicit UK retail deposits under

government guarantee. Their operations would not have been

viable under narrow banking. High rates may be promotional rates

which will be reduced after an introductory period, or offered by

banks which are trying to enter the retail savings market in an

aggressive manner. These latter practices could be expected to

continue.

Any negative effect on rates for savers of a move to narrow

banking would, therefore, be the direct result of government no

longer offering deposit insurance free. The cost of the guarantee

would be shared between the depositor and the bank, depending on

the solidity of the bank and competitive market conditions. In

normal circumstances, the price for such deposit insurance would

not be large. In current market conditions, however, the value of

such a guarantee would be significant. This is the market operating

as it should.

Narrow banks might, but need not, engage in lending

activities appropriate to retail financial institutions, particularly

consumer lending and mortgage finance. They might, but need not,

lend to small and medium size enterprises. Funding for these

lending activities would have to come entirely from wholesale


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markets, and the banks’ own capital. There are already specialist

institutions which offer credit cards and mortgages based on

wholesale funding. An expansion of such finance could take the

form of securitisation, or be achieved through more traditional

forms of money market funding. Since there would be no

regulatory advantages to one form of finance over another, market

forces would determine the outcome.

Specialist lending businesses might focus on small and

medium sized enterprises, a business until now dominated by the

retail banks. The traditional link between deposit taking and

lending established by the knowledgeable bank manager based in

the local community has largely disappeared, as lending processes

have become specialist and based on credit scoring rather than

personal acquaintanceship. (Indeed the relationship has been

reversed – the bank uses its knowledge of SME customers to target

their owners as prospects for the sale of personal financial

services).

Specialist SME lending activities might be linked to private

equity houses. When private equity was called venture capital –

before it was hijacked into the buyout of large established

businesses – private equity was becoming a promising source of

early stage finance in the UK, comparable to that available in the

United States. Government could usefully promote the

development of such businesses, perhaps based, for example, on


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relevant divisions of the Royal Bank of Scotland or the struggling

Irish banks.

It might be expected that in due course much of the finance

for both the consumer and SME lending would come from money

market funds. Sophisticated savers with larger amounts to deposit

should have the option of giving up the government guarantee and

obtaining slightly higher rates. This would be best achieved by the

development of money market funds of the kind that exist in the US

and would reduce the quantum of insured deposits. Pension funds

and insurance companies, which are currently substantial holders of

gilts, would also be natural providers of funds to specialist lending

institutions. Money funds and savings institutions would be

expected to develop skills in judging the quality of the credit

assessment of lenders. The market would take over the role of

supervision.

The US government has been trapped into providing

guarantees (supposedly temporary) for US money market funds.

There was no realistic political alternative, given that the US

financial system was awash with subsidies to much less deserving

causes.

But the UK government should avoid similar involvement.

State guarantees for money funds reduce incentives for the

managers of funds to perform their central role, as monitors of the

quality of management and lending books of specialist lending


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institutions. These subsidies are also unfair to customers who have

accepted lower returns in order to obtain the benefit of explicit

guarantees. It may be desirable to avoid the US structure, which

seeks to maintain the NAV of funds constant at $1, because this

makes the fund look similar to a deposit, and either confuses

customers or creates an expectation of government guarantee. It is

important to create very clear blue water between deposits, subject

to government guarantee, and funds, which may be subject to

market fluctuation.

Banks in the UK should be required, as US banks are, to

notify the amount of their insured deposits to government or its

designated agency. All statements to depositors should state the

existence of the guarantee and the agency through which it is

offered. Other funds, of whatever nature, seeking retail money

should be required to state that neither the principal sum nor the

projected return is guaranteed by the UK government.

The long term objective would be to dismantle all other

financial services regulation. Capital requirements would be

abandoned, and the licensing of wholesale market activities by

public agencies would relate only to the approval of individuals and

institutions as fit and proper persons. Issues such as market abuse

that did not fall within the scope of the criminal law would be a

matter for private activity by self-regulatory institutions.


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The international dimension

EU banks (for these purposes the EU includes Iceland and

Norway but not Switzerland) operate internationally under a

‘passport’ regime. Homeland and Otherland are both EU states. If a

Homeland bank takes deposits in Otherland, it can do so through a

branch in Homeland. In that case it is subject to the regulation of

Homeland and depositors from Otherland qualify for deposit

protection under the Homeland scheme. Or the bank can establish

an Otherland subsidiary, in which case the subsidiary (though not,

of course, the home bank) will be regulated by Otherland and

depositors must seek repayment from the Otherland government if

the Homeland bank fails to do so.

Fortis operated throughout Benelux, but when its position

became precarious the Belgian and Dutch governments took control

of the operations in their own countries. There was sufficiently little

integration of the substantive activities behind the common facades

that the separation of the national components appears to have

been easily achieved.

One of the two large Icelandic banks – Landsbanki – had a UK

branch while the other – Kaupthing - owned a UK subsidiary. The

Icelandic regulator lacked both the competence and the will to act

and the UK regulator did not restrain Kaupthing. When Landsbanki

failed, the resources of the Icelandic deposit protection scheme

were insufficient. The UK authorities then understandably but still


66 66

inexcusably used anti-terrorist legislation to freeze Landsbanki’s UK

assets. The Treasury was no doubt mindful of reports that

substantial Lehman assets had been repatriated to the US hours

before the collapse of that business. The UK also took control of

Kaupthing UK, which led to the immediate failure of the parent:

there will be a considerable deficiency in the liquidation.

The resulting bills will be shared among Icelandic taxpayers,

UK taxpayers, and other UK banks and building societies, and will

run into billions of pounds. The UK will have substantial liabilities

for both Kaupthing and Landsbanki. These Icelandic banks were

minnows among global financial institutions and had significant

operations in only a few countries.

The incident should be treated as a wake-up call. There are

no adequate measures to deal with a major international banking

failure. What would have happened if the struggling Royal Bank of

Scotland, whose principal retail operation is the English NatWest

bank, had been headquartered in an independent Scotland? It is

only necessary to frame the question to want to go to great lengths

not to have to answer it.

Home country regulation makes every member of the EU

dependent on the skills of the weakest regulator. Host country

regulation is inadequate because the host does not have enough

control over a large financial institution based elsewhere. Adair

Turner, Chairman of the Financial Services Authority, has shrewdly


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observed that in banking there needs to be either more Europe or

less.12 The single market would be best served if there were a

common European regulatory regime with a single regulator in

whom all member states had confidence and a single Europe-wide

scheme for deposit protection. But there is no realistic prospect of

satisfactory agreement on this in the foreseeable future.

In the meantime, as the Governor of the Bank of England has

noted, banks operate globally but die nationally. Major banks have

operated in wholesale markets with little regard for national origin

or national frontiers, but failing banks exert – and can exert -

political pressure for subsidy in the country in which their head

office is located. The will to protect depositors exists only in the

country in which the depositors reside. Icelandic taxpayers ask

why they should be liable for payments to UK depositors of

Landsbanki, and they are right to ask that question. This

demonstrated and justified unwillingness of taxpayers to subsidise

overseas adventures of irresponsible financial institutions registered

in their jurisdiction leads to the absurd proposal from the European

Commission – which the UK blocked – that member states could be

ordered to subsidise weak financial institutions registered in that

state.

The implication is that until the conditions for an effective

single market can be fulfilled – specifically, genuine willingness to

accept a single European regulator and to pool the costs of banking


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failures on a Europe-wide basis - cross-border banking must be

restricted. The interim objective should be to allow member states

to pursue different policies with the least possible damage to

competition and to the single market. The current unwillingness to

face reality implies the certain prospect of costly future bailouts.

The need to conduct cross border activities through narrow

banks is essentially the conclusion which the Turner Review reaches

from analysis of the Icelandic fiasco, and that conclusion is

inescapable. The Turner Review does not pursue the logic of its

argument to its next stage – which is that the UK retail operations

of all international banks, even those headquartered in London,

should be conducted through narrow banks. This omission is

perhaps not surprising since the alternative is to acknowledge that

the FSA cannot guarantee to prevent the failure of London based

international banks. But, of course, there can be no such assurance

without UK government subsidy.

The best route ahead, therefore, would be not only to allow,

but to strongly encourage, overseas banks (such as Santander) to

establish retail banking operations in the UK. Such competition

would also be welcomed from continental European retailers or

insurers. But this welcome is on the basis that as deposit takers

they will operate as narrow banks and be subject to the same

regulation as UK narrow banks.


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The corollary is that the UK government should make clear

that it does not allow companies which are not narrow banks, of

whatever nature and wherever registered, to solicit deposits from

retail customers in the UK (though such companies may, of course,

manage money funds). If other countries choose to allow UK

financial institutions which are not UK banks to seek deposits within

their own territory, the UK government will not guarantee their

soundness – as it cannot - or accept liability for their obligations –

as it should not.

Other EU member states should be encouraged to take a

similar view. If they choose instead to take refuge in pieties about

the value of international coordination of supervision then the UK

should take the necessary steps to protect UK depositors and UK

taxpayers from the consequences of procedures that have

demonstrably failed in the past and will continue to fail in future.

The politicians who have declined to address these questions, or to

engage in serious discussion of them, will bear a heavy burden of

responsibility in the next crisis.

It is very desirable that better regulation of financial services

should be pursued on a cooperative international basis. However to

act only on the basis of international agreement is to act at the pace

set by the country with the most powerful financial services industry

lobby (a tough competition, in which the UK is no laggard). If the


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UK (or any other country) is to become serious about regulatory

reform, it must be prepared to act unilaterally.

There is a major difference here between wholesale financial

markets, which are global, and retail financial markets, which

remain national. Even when retail financial institutions operate in

Otherland, their operations in that country are much more like

those of institutions in Otherland than their own activities in

Homeland. Thus there are few practical difficulties about unilateral

action in the regulation of retail banking, though there are some

legal difficulties, since EU directives and other international

agreements suppose (and, to be fair, hope to encourage) a

breakdown of national market segmentation that does not currently

exist.

Regulation on the basis of narrow banking would work well if

all countries adopted it, and it would also work well for the UK if the

UK adopted it even if other countries did not. But would the

unilateral adoption of narrow banking by the UK put the UK at a

competitive disadvantage in financial services?

Arguments of this kind must be taken seriously, given the

international success of the UK in financial services. But these

arguments should not be accepted uncritically: we should no longer

make the assumption which has driven UK government policy for

the last decade, and appears to continue to drive policy, that what


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is good for established businesses located in the City of London is

good for the UK.

Whether or not banking in the UK is reorganised on narrow

banking lines, UK financial institutions engaged in retail banking in

other EU member states must be required to do so through

subsidiaries rather than branches (they mostly do so in any event).

The consequence is that these overseas activities of UK banks would

be supervised by the states in which deposits are collected. Liability

for any failure would fall on the deposit protection schemes of these

other countries. There is no reason why UK taxpayers should be

liable for losses incurred by UK registered companies in other

jurisdictions, and it is likely that this is how UK taxpayers would

perceive matters if such claims were made.

A more difficult issue is posed by the position of UK based

banks in wholesale markets. UK based banks would be at a

competitive disadvantage if they were not allowed to use their

taxpayer-guaranteed deposit base as collateral for their wholesale

market activities while their competitors could. There is truth in

this argument, and although the best answer would be that all

countries should refrain from providing such subsidies, all countries

will not.

Such competitive subsidies are a clear breach of prohibitions

on state aids within the EU. The problem is again one of ambiguity,

created and aggravated by the political power of the financial


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institutions, and the panic that has crippled policy makers. In 2005

the European Court ruled that explicit state guarantees of the

activities of German Landesbanken were a violation of the EU

treaties. Such guarantees are now being phased out.

At the time, however, other major European banks preferred

to deny that their liabilities were underwritten by their governments

(although the events of 2007-8 showed that in fact they were). The

Landesbanken have not been adequately regulated or supervised

and, like other financial institutions, repeatedly lose large amounts

of money in activities extraneous to their core business.

The weaknesses of the Landesbanken, which are sometimes

used as an argument against narrow banking, are in fact a cogent

argument in its favour: when the Landesbanken operate as narrow

banks, they do a good job. But the existence of these institutions in

their present form is bound up with broader questions of the

relationship between the German Federal government and the

Länder, and the resulting skirmishes are one of the many obstacles

to the formulation of rational banking policy at the European level.

Most wholesale market activities in the City of London today

are conducted by firms whose principal retail operations lie outside

the UK. Thus the issue of cross subsidising wholesale activities

through government subsidy of retail deposit taking relates mainly

to a single UK company – Barclays – through the global investment

banking operations of Barclays Capital. (HSBC, which also has large


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and successful investment banking operations, would be little

affected by a requirement to operate its UK retail operations

through a narrow bank because its UK retail operations are much

smaller in relation to the overall size and resources of the bank).

The enforcement of narrow banking would require that Barclays

Capital sink, or swim, as a standalone entity without recourse to the

resources of Barclays retail arm. From the perspective of UK

depositors and taxpayers, this must be the right solution.

Financial sector reform is largely a matter for two countries –

Britain and the United States. The dominance of these two

jurisdictions in global financial markets is such that even if other

countries are not obliged to follow the lead they set, other countries

are obliged to operate within the framework Britain and the United

States define.

This outcome is, understandably, widely resented.

International discussions of regulatory issues and of structural

reform have in reality little to do with the declared objectives, or

the establishment of a more stable financial system better adapted

to the needs of customers. The debate represents the use of

international political institutions to achieve national advantage:

and for these purposes national advantage means the advantage of

producer groups based in, or influential in, the countries concerned.

This self-interested bickering is an inevitable consequence of the

degree of capture of regulatory institutions and politicians by


74 74

industry interests. Until this stranglehold is broken, well-meaning

efforts to secure more international cooperation in the regulation of

financial services are likely to do more harm than good.


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Payment systems

Payment systems are the essential utility that the financial

services industry provides to households and non-financial

businesses. In the United States in March 1933, this utility failed.

It has not done so anywhere during the 2007-9 crisis.

There are four principal payment schemes in the UK13

− The real time gross settlement system (RTGS). Only a

system which operates in real time can give immediate finality

to a transaction (i.e. ensure that the recipient has the money

regardless of the status of the bank or the payer). All high

value transactions are made in this way. CHAPS (clearing

house automated payment system) is operated through the

Bank of England and jointly owned by the participating banks

and the Bank of England. It has been estimated that CHAPS m

accounts in Britain for 90% of transactions by value but only

0.2% of transactions by volume.

− The batch payment system, by which payments between

banks are aggregated in a clearing house. Net settlements

between banks are made at intervals using the real time

system. These mechanisms include the functions of the old

paper-based settlement systems (BACS – bankers automated

clearing system) and the Link (ATM) system for obtaining

everyday cash. The clearing house is owned by the major

banks.


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− the card system, which principally functions through two

networks, VISA and Mastercard. Both networks were

originally established and owned by banks, but developed a

strong identity of their own and have been floated as

independent companies. VISA Europe, however, is still owned

by member banks. In reality, the card system is mainly

administered by a small number of technology-based

processors such as First Data although the issue of cards and

making of payments is channelled through banks

− the cash system, owned and operated (under statutory

monopoly) by the Bank of England through banks as agents.

In addition, small independent payment systems have

developed to meet specific needs which are not met, or met only at

disproportionate cost, by the principal payment systems. Paypal

(owned by eBay) allows individuals to make low value transactions

with an element of real time finality; Western Union and other

providers provide dedicated channels for modest international

transactions such as migrant remittances. Mobile phone based

payment systems are now a significant element in the financial

systems of poor countries such as Kenya where the mobile phone

network is almost the only effectively functioning infrastructure.14

They can be used for small transactions in the UK. Stored value

cards (such as an Oyster card)can be substituted for cash

payments.


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Payment systems are numerous, and proliferating, principally

because the core systems have been slow to innovate and respond

to changing needs. The Faster Payments System, designed to allow

payments of routine bills, wages and salaries to be made on a time

scale of less than three days, came into operation only in 2008 and

is still seriously limited in its scope. Card based systems have

developed in parallel to, rather than as an integral part of, the

principal payment systems. Many innovations are coming from

businesses outside financial services, such as eBay and PayPal, from

transport undertakings and their suppliers, and from phone

companies.

The future could be different. There are two basic payments

needs. One – the traditional role of cash – is for a portable

mechanism of payment. Value is guaranteed; transactions can be

undertaken anywhere, and can be anonymous. The other

requirement, for higher value payments – the traditional role of the

current account – requires access to the purchaser’s deposit or line

of credit with a financial institution.

Both needs can now be efficiently met by modern information

technology. The first requirement needs an electronic wallet and

the wide replacement of cash by prepaid storage cards. The second

needs an online connection to a centre linked to financial

institutions, providing low cost, real time, final electronic transfer of

funds between individuals and businesses. If both systems were


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fully developed all payments could be made by waving a card or

clicking a mouse. A world of simple, secure and cheap money

transfer in which cash was mostly confined to illicit transactions

would look very different. The social implications and savings to

business could be substantial.

It is probably in the retail sector, rather than in wholesale

markets, that opportunities for financial innovation with substantial

economic and social impact are to be found today. But issues in

retail banking receive little attention relative to those which arise in

wholesale markets: certainly there are a hundred articles on the

valuation of derivatives to every one on the benefits of real time

gross settlement. And when bankers talk about innovation in

financial markets, they are almost always talking about new

products in wholesale markets (sometimes about new sales

techniques in retailing) and almost never about improvement in the

provision of core financial services. This emphasis is another

reflection of the Cinderella status of retail banking.

Different countries have reached different stages of evolution

in payment systems. Cheques are no longer used in Japan or the

Netherlands: stored value cards are popular in Belgium. Britain

and the United States, the principal innovators in wholesale financial

markets, are laggards in the development of payment systems, and

this is probably not a coincidence.


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Established banks do not have, or do not see themselves as

having, much to gain from change, and many have struggled with

the implementation of new technology platforms. Restricted access

to the existing payment systems makes new entry in retail financial

services more difficult. Charging structures for transactions

frequently lack transparency and rarely bear any relationship to

underlying costs.

In Europe, banks were slow to respond to the creation of the

Eurozone. They underestimated the political imperative of making

the single currency a reality in the daily lives of ordinary Europeans.

Such a transaction required a shift from cumbersomely linked

national payment systems to a single European regime. The foot-

dragging prompted the European Commission and Parliament to

take control of the issue, with positive results, culminating in the

creation of the Single Euro Payment Area in 2008.

In his report on UK banking in 2000, Don Cruickshank

correctly identified the organisation of the payment system as a

major obstacle to the development of a competitive retail market.

He recommended that a payments regulator be established with

power to set price caps and determine access provisions, on the

lines of the utility regulators which exist for other infrastructure

industries. This proposal was initially accepted by the government.

It was, however, successively watered down in the face of industry

lobbying, culminating in the establishment in 2007 not of a


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regulator but of a Payments Council, a membership organisation

controlled by the industry (though with some independent

representatives).

It is time not only to revive Cruickshank’s recommendation,

but also to go further than he proposed. Narrow banks should in

future be the only conduit to the payments system. Under narrow

banking extensive reserve requirements are imposed on narrow

banks. The principal reason for distinguishing real time gross

settlement from delayed net settlement – the different amounts of

collateral required to support transactions – consequently

disappears. At the same time, a regulator might review the

interchange fees imposed on merchants for credit card transactions

– which have the effect of setting a floor to merchant acquisition

charges.

It would be for the market, not the regulator, to decide the

future shape of the payments system. But the regulator can, and

should, give full rein to market forces. In other industries, such as

electricity, the separation of the network from its suppliers has had

a positive effect on competition, efficiency, and innovation. The UK

has experienced a modest pace of innovation. New entrants to

retail financial services have been obliged to partner well

established firms to establish a market position. New developments

in payments have taken place outside the established framework.


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There is considerable scope for enhancing competition, efficiency

and innovation in this sector.

The utility model, which divorces control of the underlying

infrastructure from product providers, is a useful parallel. The

objective might be Britpay plc, regulated by Paycom. Britpay might

be owned, or perhaps franchised to, a consortium of technology

companies rather than a consortium of banks, or perhaps be floated

as an independent business. Breaking up the banks opens up a

new range of options. There is plenty room for excitement in

narrow banking.


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The future shape of the financial services industry

Consumers are poorly informed about financial services

products, easily misled, and have frequently been offered

inappropriate services or ones that represent poor value. Many of

them do not like dealing with financial matters. This information

asymmetry provides a substantial justification for the regulation of

financial services.

It is often suggested that the answer to information

asymmetry is more information, and regulators have required

providers to offer much more extensive descriptions of products and

practices. But information asymmetry is found in many markets for

complex goods and services, and persists because consumers have

neither time nor inclination to seek or absorb more information.

Many people who deplore public ignorance in financial services

matters would hesitate to open the bonnet of their car, or to

distinguish their larynx from their thorax. The consumer is confident

in purchasing products such as automobiles or medical services,

about which he or she knows little, as a result of the efforts

producers invest in developing good reputations with their

customers, and because users are able to access the skills of

trusted intermediaries.

Producer reputation and reliable intermediation are the

mechanisms through which markets handle information asymmetry.

If there is a problem in financial services – and there is – it is


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because producers have had little regard to their long run

reputation and because intermediaries have not deserved the trust

of consumers. There is wide discussion in the financial services

industry of the need to restore trust. Such discussion rarely

focuses, however, on changes in the structure or behaviour of the

industry. The issue is perceived as one of public relations. But the

problem is one of substance, not appearance.

It is not appropriate, or realistically possible, for public

agencies to prescribe in detail the conditions and methods by which

financial services products are sold. Regulation is necessary,

supervision is undesirable, and so regulation should work with

market forces rather than to supplant them. The principal

successes of the financial services regime since 1987 have used this

approach. The ‘naming and shaming’ of major providers for

misselling pensions and endowment mortgages has encouraged the

firms concerned to protect their reputations by reforms of their

internal processes.

Regulators have also enjoyed success in improving the

performance of intermediaries. But the process is slow. By 2012 –

twenty-five years after the present structure was instituted – the

FSA may have succeeded in ending the custom by which bribes

from providers were the principal means of remunerating

intermediaries. The fundamental problem, however, is that

individual financial advice of even moderate quality is prohibitively


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expensive for a mass market. The general public can be best

served, in financial services as in most other product areas, by the

presence of effective retailers.

I recently spent time with a large, professional, dairy farmer.

His farm was subject to a variety of inspections by government

officials. Not supervisors – none were concerned with whether his

business was well run (it is). The purpose of their visits was to

address specific public interest concerns – to ensure compliance

with legislation on health and safety, to test his animals for

tuberculosis. But the inspections that concerned the farmer most

were those made by the cooperative to which he sold his milk and

most of all inspections by Marks and Spencer and Waitrose, who

were the ultimate buyers.

This is the regulatory role which good retailers play in modern

business. They succeed by being sensitive and responsive to the

needs of their customers on the one hand, and demanding in the

price and quality they expect from their suppliers on the other.

Their existence does not eliminate the need for statutory regulation,

but it reduces it. In areas such as product safety the vigilance of

retailers acts as a powerful supporting control mechanism. To the

extent that the farmer’s business is supervised, it is supervised by

retailers. The efficiency with which such supervision is performed is

a key competitive advantage of a good retailer.


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Retailing of financial services has been very different.

Historically, banks were horrified by the notion that they were

retailers at all. As with many other cartelised or monopolised

industries – think of the nationalised telephone network – banks

treated their customers as applicants for their services.

More recently, however, the culture has become sales driven,

but undesirably so. Retail activity is an outlet for product. ‘Life

insurance is sold, not bought’ was a slogan of the insurance

business, as ignorant salesman on commissions bludgeoned

customers into buying inappropriate products. This long and

disgraceful tradition infected the conglomerate banks when they

sought, in the 1980s, to become ‘bancassurers’. Banks emphasise

the importance of cross-selling of products: but such discussion

almost always describes the advantages to the bank, not the

advantages to the customer. Products offered through cross-selling

are rarely competitively priced.

Both the dot.com bubble and the sub prime mortgage crisis

were the result of giving sales forces substantial incentives to

peddle products that were unsuitable for customers but enabled the

providers to report substantial, if often illusory, profits. Banks have

too often been guilty of petty abuse of customers, as in the levying

of penal charges for minor overdraft or credit card lapses and the

pushing of overpriced payment protection insurance.


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It is hard to resist the conclusion that the selection of retail

products offered is driven more by the margins earned than by the

needs of customers. The two principal ‘funds supermarkets’ –

which negotiate discounts on fund charges and pass most of them

on to customers – are Cofunds and Funds Network, developed not

by retailers but by fund providers themselves. Exchange traded

funds – which allow retail customers to build diversified portfolios at

very low cost – are one of the most useful modern innovations for

the small investor. But although Barclays was the global leader in

the development of these instruments, a customer could

successfully access them through a Barclays retail outlet only with

some difficulty and only if he or she were already well informed.

All retailers survive, of course, from profits on the products

they sell. But a strategy of focussing on high price goods because

they offer larger retail margins is the opposite of the business

model pursued by successful retailers such as WalMart and Tesco.

These firms have instead pursued volume growth through

competitive pricing, building a sustainable long term relationship

with their customers through a justified reputation for value for

money. A more competitive market, facilitating new entry, would

not only allow but encourage businesses to adopt a similar approach

to financial services. It is likely that WalMart and Tesco would be

among them.


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Regulators have had some success in curbing excesses – the

most egregious practices of life insurance salesmen have been

ended, for example. But viewing the performance of the industry

as a whole it is hard to conclude that customers are better treated

than they were twenty years ago. As one historic problem is

eliminated – the misselling of personal pensions – a new one

emerges – encouraging households to take on unaffordable debt.

The product driven culture is a predictable consequence of vertical

integration in the financial services industry.

Indeed the problem goes deeper than vertical integration. It

is not in the interests of lending institutions for their customers to

take out loans these customers cannot repay. The driving force in

the sub prime crisis was the profitability of securitised products for

the individuals who sold them, at both wholesale and retail levels.

These instruments were created in investment banks, and the

investment banking operations of conglomerate banks:

organisations more appropriately regarded as collections of greedy

individuals than as corporate organisations with an interest in

sustaining the reputation and value of the business. Their

transactions oriented culture corrupted the retail sector, whose long

run viability depends – as does most retailing – on the development

of trust relationships with customers.

It is hard to think of a worse response to this problem than

the award of large subsidies to the failed conglomerate institutions


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responsible, combined with a pretence that similar problems will in

future be prevented by a system of supervision dominated by

financial services interests. The future health of the financial

services industry depends on the creation, or perhaps re-creation,

of a customer-focussed retail sector. The assessment of the value

of new products is best carried out, as in most of the economy, not

by manufacturers or regulators but by competent retailers in close

touch with the needs of their customers.

Some of these retailers from other sectors will themselves

have a major role to play in the future of the financial services

industry – or at least will do so if market forces, rather than political

lobbying, is allowed to determine the future shape of financial

services. Firms such as Marks and Spencer, Tesco and Sainsbury

have made forays into the provision of financial services, but so far

they have mostly been content to shelter under the umbrella of the

ample margins available on established products. They have not

yet been aggressive in either pricing or product development.

Supervisory restrictions closely related to established business

methods are, and are bound to remain, an obstacle to innovation.

These retailers, and businesses like them, are likely purchasers or

founders of narrow banks. Other utility retailers, notably mobile

phone companies, might also see an opportunity.

In the short run, it is likely that narrow banks would mostly

be subsidiaries of financial holding companies. But if retail banking


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activities were effectively ring-fenced from investment banking, it is

probable that traders and investment bankers would lose interest

and the subsidiaries would be sold or floated. Their interest in the

retail sector is in the money, not the business. Other financial

services companies, such as insurers who choose to focus on retail

operations, might be potential operators of narrow banks.

The excesses of the last decade raise questions as to whether

ownership by a listed company is an appropriate structure for a

narrow bank. In financial services the short-term profit orientation

of such companies in financial services has hurt the reputation of

the industry, the wider economy, and ultimately the businesses

themselves. There is an issue here, but the success of retailers

outside financial services in developing the confidence of customers

provides some reassurance that it is possible for listed companies to

take a longer term view.

Still, it is now apparent that the conversion of the mutual

building societies to public limited companies did, in the end, inflict

considerable damage on the UK financial services sector. All the

large societies which converted either failed or were absorbed into

large financial conglomerates. This reduced competition and the

institutions which were eliminated had achieved significantly higher

levels of customer satisfaction than their listed counterparts.

The clock cannot be turned back. But there was no

compelling business argument for conversion. The societies were,


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in the main, strongly capitalised and well able to grow their

business organically or to access capital markets. But as bank

share prices rose after the recession of the early 1990s it became

evident that substantial windfall gains could be created for

customers by sale or flotation. When Lloyds’ purchase of the

Cheltenham and Gloucester Building Society demonstrated the

possible scale of the windfalls, it was effectively impossible to resist

pressures to offer them. (It is a strange footnote that Nationwide,

the least attractive conversion candidate because it was seen as a

poorly managed business, is today the largest specialist mortgage

bank).

There is no case for subsidy or artificial protection of mutual

or not for profit financial institutions. But there is a strong

argument for establishing a legal framework which would prevent

the realisation of the assets and goodwill of businesses for the

benefit of a single generation of customers. Mutuals would then

compete with profit-making companies on the merits of the

alternative business models, and would not be destabilised by

extraneous factors.

It is sometimes argued that narrow banks would be boring,

and would be attractive only to untalented people. ‘Retail is detail’

is a mantra of shopkeepers. The challenges of financial services

retailing are likely to be boring for people whose eyes light up at the


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description of a CDO squared, the calculation of the value of an

exotic derivative, or the prospect of a large corporate acquisition.

But that is the problem. People such as these, talented

though they may be, should not be running retail financial services

businesses. The people who should be in charge of these

businesses are customer focussed. Not at all untalented, they

recognise that retail is detail and derive their satisfaction from

identifying the needs of their shoppers and meeting these needs

more effectively. Many such individuals are already employed in

the financial services sector. It is time to give them their

opportunity, free of the distorting and – in the last decade,

massively disruptive – influence of the deal makers, traders and

investment bankers, who dominate financial conglomerates.

Narrow banking is desirable not just because it provides a

sounder basis for regulation of the banking industry, important

though that issue is. The implementation of narrow banking would

provide a catalyst for the restructuring of the financial services

industry - a restructuring which would create a sector focussed on

innovation and service directed to the needs of its customers.


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Conclusions

The case for narrow banking rests on the coincidence of three

arguments. First, the existing structure of financial services

regulation (supervision) has failed. Consumers are ill served, the

collapse of major financial institutions has created the most serious

economic crisis in a generation, and the sector has been stabilised

only by the injection of very large amounts of public money and

unprecedented guarantees of private sector liabilities.

It is time to learn lessons from the more successful regulation

of other industries. Those lessons point clearly to the need to

retreat from supervision and to regulate through the mechanism of

relatively simple, focussed structural rules.

Second, the most effective means of improving customer

services and promoting innovation in retail financial services is

market-oriented. It is based on the ability of strong and dynamic

retailers to source good value products from manufacturers and

wholesalers and to promote consumer oriented innovations. The

growth of financial conglomerates, a consequence of earlier

measures of deregulation, has not been in the interests of the public

or, in the long run, of the institutions themselves.

Third, a specific, but serious, problem arises from the ability

of conglomerate financial institutions to use retail deposits which

are implicitly or explicitly guaranteed by government as collateral


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for their other activities and particularly for proprietary trading.

The use of the deposit base in this way encourages irresponsible

risk taking, creates major distortions of competition, and imposes

unacceptable burdens on taxpayers. Such activity can only be

blocked by establishing a firewall between retail deposits and other

liabilities of banks.

This is a game for high stakes. The financial services industry

is now the most powerful political force in Britain and the US.15 If

anyone doubted that, the last two years have demonstrated it. The

industry has extracted subsidies and guarantees of extraordinary

magnitude from the taxpayer without substantial conditions or

significant reform. But the central problems that give rise to the

crisis have not been addressed, far less resolved. It is therefore

inevitable that crisis will recur. Not, obviously, in the particular

form seen in the New Economy boom and bust or the credit

explosion and credit crunch, but in some other, not yet identified,

area of the financial services sector.

The public reaction to the present crisis has been one of

unfocussed anger. The greatest danger is that in the next crisis

populist politicians will give a focus to that anger. In the recent

European elections, these parties of dissent gained almost a quarter

of the British vote, and made similar inroads in several other

European countries. The triumph of the market economy was one

of the defining events of our lifetimes. We should be careful not to


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throw it away. It is time to turn masters of the universe into

servants of the public.

19,918

1 There are now several good descriptions of the events of 2007-8. I have found the Turner Review, Milne (2009), and the collection of articles in Critical Studies, edited by Jeffery Friedman (2009) particularly useful. 2 HM Treasury (2009). 3 Compare Greenspan (2002) and Greenspan (2008). 4 See, for example, the observations in 2006 by John Tiner, chief executive of the FSA, and Sir John Gieve, Deputy Governor for Financial Stability. 5 As in Frydman and Goldberg (2008) 6 Conservative Party (2009). 7 See Bishop and Kay (1992) for a comparative survey of regulatory experiences across other industries (including financial services), Barth et al (2006) is a discouraging survey of international experience of financial services regulation. 8 Kahn (1988, second revised edn.). 9 Bryan (1988). Litan (1988) expounded similar arguments. 10 Interview in Financial Times, 9 July 2007. 11 The traditional lender of last resort function, as described by Bagehot in 1873 after the collapse of Overend Gurney, has been made redundant by deposit protection and disintermediation. The term is now used in a general way to describe central bank support of failing financial institutions. 12 In his presentation of the Turner Review. 13 A comprehensive description of the UK payment system is in Rambure and Nacamuli (2008) 14 See www.safaricom.co.ke 15 A powerful exposition is provided by Johnson (2009).


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